Financial products refer to instruments that help you save, invest, get insurance or get a mortgage. These are issued by various banks, financial institutions, stock brokerages, insurance providers, credit card agencies and government sponsored entities. Financial products are categorised in terms of their type or underlying asset class, volatility, risk and return.
Types of financial products
- Shares: These represent ownership of a company. While shares are initially issued by corporations to finance their business needs, they are subsequently bought and sold by individuals in the share market. They are associated with high risk and high returns. Returns on shares can be in the form of dividend payouts by the company or profits on the sale of shares in the stockmarket. Shares, stocks, equities and securities are words that are generally used interchangeably.
- Bonds: These are issued by companies to finance their business operations and by governments to fund budget expenses like infrastructure and social programs. Bonds have a fixed interest rate, making the risk associated with them lower than that with shares. The principal or face value of bonds is recovered at the time of maturity.
- Treasury Bills: These are instruments issued by the government for financing its short term needs. They are issued at a discount to the face value. The profit earned by the investor is the difference between the face or maturity value and the price at which the Treasury Bill was issued.
- Options: Options are rights to buy and sell shares. An option holder does not actually purchase shares. Instead, he purchases the rights on the shares.
- Mutual Funds: These are professionally managed financial instruments that involve the diversification of investment into a number of financial products, such as shares, bonds and government securities. This helps to reduce an investor’s risk exposure, while increasing the profit potential.
- Certificate of Deposit: Certificates of deposit (or CDs) are issued by banks, thrift institutions and credit unions.They usually have a fixed term and fixed interest rate.
- Annuities: These are contracts between individual investors and insurance companies, where investors agree to pay an allocated amount of premium and at the end of a pre-determined fixed term, the insurer will guarantee a series of payments to the insured party.
Complex Financial Products
There are certain financial products that are highly complex in nature. Among these are:
- 1. Credit Default Swaps (CDS): Credit default swaps are highly leveraged contracts that are privately negotiated between two parties. These swaps insure against losses on securities in case of a default. Since the government does not regulate CDS related activities, there is no specific central reporting mechanism that determines the value of these contracts.
- 2. Collateralized Debt Obligations (CDO): These are securities that are created by collateralizing various similar debt obligations such as bonds and loans. CDOs can be bought and sold. The buyer gains the right to a part of the debt pool’s principal and interest income.
CDS and CDO products played a major role in the financial crisis of 2008. During these troubled times, CDO ratings reflected incorrect information on the credit worth of borrowers, concealing the underlying risk in mortgage investments. Meanwhile, the size of the CDS market far exceeded that of the mortgage market in mid-2007. Thus, when the defaults began to unfold during the financial crisis, banks were not in a position to bear the losses.
One of the most significant factors to consider when choosing financial products is your risk appetite. Risky investments are usually associated with higher returns than safer investments. According to empirical data, shares usually outperform all other investments over the long term. However, in the short term, shares can be extremely risky due to their random and volatile nature.